Financial Crises and Lending of Last Resort in Open Economies Luigi Bocola Northwestern University, Federal Reserve Bank of Minneapolis, and NBER Guido Lorenzoni Northwestern University and NBER Staff Report 557 October 2017 DOI: https://doi.org/10.21034/sr.557 Keywords: Financial crises; Dollarization; Lending of last resort; Foreign reserves JEL classification: F34, E44, G11, G15 The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. __________________________________________________________________________________________ Federal Reserve Bank of Minneapolis • 90 Hennepin Avenue • Minneapolis, MN 55480-0291 https://www.minneapolisfed.org/research/ Financial Crises and Lending of Last Resort in Open Economies∗ Luigi Bocolay Guido Lorenzoniz October 2017 Abstract We study financial panics in a small open economy with floating exchange rates. In our model, bank runs trigger a decline in domestic wealth and a currency depreciation. Runs are more likely when banks have dollar debt. Dollar debt emerges endogenously in response to the precautionary motive of domestic savers: dollar savings provide in- surance against crises; so when crises are possible it becomes relatively more expensive for banks to borrow in local currency, which gives them an incentive to issue dollar debt. This feedback between aggregate risk and savers’ behavior can generate mul- tiple equilibria, with the bad equilibrium characterized by financial dollarization and the possibility of bank runs. A domestic lender of last resort can eliminate the bad equilibrium, but interventions need to be fiscally credible. Holding foreign currency reserves hedges the fiscal position of the government and enhances its credibility, thus improving financial stability. Keywords: Financial crises, Dollarization, Lending of Last Resort, Foreign Reserves. JEL codes: F34, E44, G11, G15 ∗First draft: August 29, 2016. We thank Mark Aguiar, Fernando Alvarez, Javier Bianchi, Charles Brendon, Fernando Broner, Alessandro Dovis, Pierre-Olivier Gourinchas, Matteo Maggiori, Fabrizio Perri, and partic- ipants at EIEF, CSEF-IGIER 2016, EEA-ESEM 2016, Cambridge-INET 2016, ASSA 2017, CREI, PSE, Boston College, Cornell, Carnegie Mellon, Wharton, University of Chicago, MFS 2017 spring meeting, IMF, Federal Reserve Bank of Richmond, SED 2017, NBER SI 2017, ITAM-PIER 2017, Stanford SITE 2017, Federal Reserve Board, Columbia, NYU, Duke, and MIT. Jane Olmstead-Rumsey provided excellent research assistance. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve System. yNorthwestern University, Federal Reserve Bank of Minneapolis and NBER zNorthwestern University and NBER 1 1 Introduction After the financial crisis of 2007-2008, there has been a renewed interest in understanding financial panics and in designing appropriate policy responses. Financial panics are situ- ations in which banks suddenly lose access to short-term funding, leading to asset sales, a sharp downward adjustment in asset prices, and a contraction in credit. The standard recipe for dealing with financial panics is relatively well understood, going back to Bagehot (1873). The central bank can stop a panic by providing ample access to emergency funding to distressed banks, that is, by acting as a lender of last resort. For emerging economies with an open capital account, financial panics tend to go to- gether with other sources of stress. A domestic financial crisis is often associated with an international flight from domestic assets that leads to a depreciation of the domestic currency (Kaminsky and Reinhart, 1999). A depreciation in turn can further exacerbate the crisis if, as is often the case, domestic banks or firms are indebted in foreign currency (Krugman, 1999). This combination of tensions makes it especially challenging for domestic authorities to effectively act as lenders of last resort. Financing the intervention by expand- ing the domestic money supply can lead to inflationary concerns and further exacerbate the currency depreciation. Financing it by issuing government bonds may be limited by investors’ concerns about public debt sustainability. Several economists and policymakers have suggested that the buildup of foreign cur- rency reserves in emerging markets over the past twenty years is a response to the chal- lenges just described. A large stock of foreign reserves, the argument goes, helps domestic authorities intervene in a financial panic, acting—in Mervyn King’s language—as do-it- yourself lenders of last resort in US dollars to their own financial system.1 The idea that reserves are needed to fight the combination of an “internal drain” (a domestic bank run) with an “external drain” (a capital flight) also goes back to Bagehot(1873), and it has been recently articulated by Obstfeld, Shambaugh, and Taylor(2010), who provide cross-country empirical evidence in its support.2 Complementary evidence by Gourinchas and Obstfeld (2012) shows that foreign currency reserves are indeed effective at reducing the probability of financial crises. There are, however, several open questions regarding lending of last resort in emerging market economies. The theoretical argument for why reserves help lending of last resort 1From a speech given as governor of the Bank of England (King, 2006). 2They show that the size of the banking sector, measured by bank deposits, plays a crucial role in ex- plaining variation in reserves holdings across countries and across time. In related work, Aizenman and Lee (2007) document that foreign reserve stocks are related to financial openness and to measures of exposure to financial crises. 2 has been developed in the context of pegged exchange rate regimes.3 It is thus puzzling that the acceleration in reserve accumulation by emerging markets occurred over a period during which many of these economies abandoned hard pegs and opted for more flexible exchange rate arrangements. What is the argument for reserve accumulation in a floating exchange rate regime? Furthermore, a common concern with ex post financial interventions is that they can distort incentives to take risk ex ante. In our context, the concern is that the accumulation of reserves to support the financial sector during a crisis might backfire and induce domestic agents to borrow more in foreign currency, through a mechanism similar to the one in the literature on bailout guarantees (Burnside, Eichenbaum, and Rebelo, 2001a; Schneider and Tornell, 2004; Farhi and Tirole, 2012). This means that we need to address two questions: What are the fundamental forces that give domestic agents incentives to borrow in foreign currency? Do these incentives get worse when government intervention is expected? In this paper we formulate a model that can help us understand how panics play out in open economies and shed some light on the questions above. Our model features a fully flexible exchange rate regime and it captures explicitly the decisions of the private sector regarding the currency composition of its assets and liabilities. First, we show that our environment can generate multiple equilibria with a bad equilibrium in which domestic financial institutions primarily issue dollar debt and are prone to runs. Differently from existing theories, dollar debt arises in equilibrium because domestic savers want to save in dollars as a way of insuring against financial panics. We then provide an argument for why foreign currency reserves improve financial stability in a floating exchange rate regime. The main idea is that reserves are a good hedge against the pessimistic expectations of the private sector, and they can thus help official authorities to credibly intervene to eliminate bad equilibria. Surprisingly, in our framework these interventions can have a stabilizing effect ex ante, leading to less dollar debt. Our model combines ingredients from the recent macro-financial literature (Gertler and Kiyotaki, 2010; Brunnermeier and Sannikov, 2014; He and Krishnamurthy, 2015) with a standard open economy framework. There are two domestic agents, households and bankers, and risk-neutral international investors. Households work for domestic firms and save in domestic and foreign currency. Bankers borrow in domestic and foreign currency, and use these resources along with their accumulated net worth to purchase domestic as- sets, which are used as inputs in production. The model features two sources of financial frictions: banks face a potentially binding financial constraint, and foreign investors only 3The argument in Bagehot(1873) was made in the context of the gold standard. Modern versions of this argument— for example, the model in Section 3 of Obstfeld, Shambaugh, and Taylor(2010)— build on models of currency crises originating from unsustainable pegs. 3 borrow and lend in foreign currency. We first show that a financial panic triggers a depreciation through its effects on domes- tic wealth and domestic demand. In particular, when banks lose access to funding, asset prices and credit fall, and so does in equilibrium the wealth of domestic households. The associated decline in the demand for domestic goods requires the relative price of non- tradables to fall. This Balassa-Samuelson channel leads to a pattern of comovement that is important for the analysis to follow: in a crisis, domestic asset prices, banks’ net worth, the real exchange rate, households’ incomes, and the fiscal capacity of the government all fall at the same time.